What does an inverted vol term structure signal?

Question

AcadiFi · Accepted Answer

An inverted vol term structure — short-dated implied vol above long-dated — almost always signals an acute stress event priced with mean reversion. In calm markets the curve is upward sloping (contango) because short-dated ATM vol trades near realized vol (15-18) while long-dated trades closer to a long-run average (18-22). Three interpretations when the curve inverts: 1. Event risk. An earnings release, FOMC decision, or election concentrated in the near term inflates short-dated vol without moving longer expiries. This is a mechanical inversion that usually reverses within days. 2. Acute stress. March 2020, October 2008, August 2015 — spot crashes cause front-month vol to spike above 40-60 while 1-year vol lags because mean reversion is priced in. These inversions correlate with drawdown. 3. Vol-of-vol signal. Steeply inverted curves mean the market expects the current regime to normalize. The steeper the inversion, the stronger the implied mean reversion speed. ```mermaid flowchart TD A[Curve
Inverts] --> B{Driver} B --> C[Event
Risk] B --> D[Acute
Stress] B --> E[Mean
Reversion] D --> F[Calendar
Spread Buy] ``` A trade: Crestfield Global positions a calendar spread, buying 6-month vol and selling 1-month vol when the 1m/6m ratio exceeds 1.15. Historical backtests show positive carry as the inversion normalizes. The risk is extension — if the crisis lengthens (2020 March-May) the trade can widen before converging. For FRM exam: inversion is consistent with both Heston-style mean-reverting dynamics and jump-diffusion pricing.

What does an inverted vol term structure signal?

Master Part I with our FRM Course

Related Questions

Practice Questions